Capital Ideas: The Improbable Origins of Modern Wall Street. By Peter L Bernstein. Free Press; 340pp; £17.50. Review by David Morton.
On "Meltdown Monday," 19 October 1987, America's stock markets managed to lose some $600 billion in just six and a half hours. This came as something of shock to the people whose money it had been. As in the case of the Chernobyl nuclear reactor everyone had rather presumed there were systems to stop this sort of thing from happening.
Many people thought that everything was safely in the hands of a new generation of "scientific" investment managers, wizards who had brought to the markets whole sets of computer systems and statistically-based techniques designed to prevent the melting away of the funds they managed." "Portfolio insurance", described as "downside protection with greater upside participation" had become the financial world's equivalent of safe sex. Yet in the postmortems that followed the Crash, it was these safety systems which were blamed for drawing the market on to disaster. Market professionals felt that it was portfolio insurance, rather than any greed-is-good ethos, which helped fuel the "bonfire of vanities". Bernstein's book is a fascinating case for the defence of a source of quiet academics who had devised the new systems - the "Quants, Computer Nerds and Rocket Scientists", as they were headlined - who had followed their statistical findings as far as they could logically go, and discovered that they had walked right up Wall Street.
among the defendants are a high proportion of Nobel Prize winners. Modigliani (Nobel Prize 1985) and Miller (Nobel Prize 1990), for example, demonstrated - statistically and logically - that it really didn't matter whether a business was up to its neck in debt and didn't pay any dividends. Non-Nobel Prize winners have tended to take a contrary view as they regarded the desolation caused by the debt explosion of the '80s, the takeover craze funded on funny paper, the disappearance of some of America's most respected corporations and the loss of jobs in stable communities.
In this, as in each case, Bernstein provides an excellent summing up of the theory, the reality and what the academics have to say for themselves. Bernstein is "for the defence" but readers are given enough information to be their own judge, jury or hangman as the book progresses.
One plea in mitigation is that almost all the academics were drawn to the market not in search of riches, but for numbers they could crunch in their work on probability and trends. Stock markets happened to be the places where a profusion of numbers ("prices" to the commercial-minded) were recorded. What the academics discovered in these numbers was the "random market", where prices are just as likely to go down as up. More important, they discovered that even the best forecasts produced by the investment experts were only as good as the best forecast derived from a random shuffling of cards. The predictions of the worst investment specialists were actually worse than the worst forecasts produced by the playing pack. The academics also found that, in order to improve on the investment experts, all you had to do was stop trying to "beat the market" by picking "winning shares" (which had a nasty tendency of turning into losing shares) and simply "join the market" by buying a portfolio of all shares. In short, "more money for less worry."
At first, as far as Wall Street was concerned, it was as if a group of train-spotters had discovered the meaning of life. It was not the meaning the experts wanted. Not were these the sort of people they wanted to hear it from. In any case, the cost and logistical problems of buying some of every stock on the real market also made it impractical.
Nevertheless, the development of the derivative "futures" markets, and "synthetic" financial instruments based on a computer-calculated index of all shares, began to overcome the practical objections. Then came the realisation that, by carefully playing off the "derivative" and the "real" markets against each other, the "computer nerds" could lock into an insurance policy that would pay up if the market soared. And all without worrying whether the firms you were investing in made computers or coffins, profits or losses.
A Wall Street convert to portfolio insurance, Bernstein saw how these ideas were initially ignored and then came to triumph and disaster. He has a real gift for making tangible the more arcane aspects of the financial markets, and of describing the maths that underpin many of the ideas without torturing the innumerate. Also he has interviewed just about everybody involved from the earliest evolution of these ideas in the quietest and most humdrum groves of academe.
But what about the insurance policy that was supposed to come up trumps even if the market crashed. Unfortunately the chaos of the falling markets on that Monday in October 1987 prevented all the neat maths from going into action and the disjointed strategies that could be carried out merely added to the confusion and to the market's fall.
Oh well, back to the blackboard.
David Morton is a freelance writer.